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Economics Explainer: What is Bitcoin?

December 13, 2018

Bitcoin. We hear when its value goes up, or when its value goes down. We hear that so-and-so has become a millionaire from bitcoin, or that so-and-so has lost millions from it. But how does it work? Why do people use it? And what exactly is it? 

 

Visual by Elena Koskinas

 

 

Why is Bitcoin so talked-about?

 

After being invented in 2009, it’s become a bit of a buzzword – it’s always being mentioned that the value of bitcoin either went up or down on the news. In fact, the value of bitcoin is continually moving dramatically up and down – one bitcoin used to be worth a couple of cents, but now it’s more than $9000 per coin. Because of this changing value, heaps of people have literally become millionaires from the bitcoin they own. (You might have heard of the guy who threw out his hard drive with 7500 bitcoins on it – if he had kept it, he would have had almost $70 million today).

 

 That guy, right now

 

 

What is it, actually?

 

So what is bitcoin? Physically? Actually?

 

 

Firstly, it’s not a real, physical thing. It’s a "cryptocurrency". A cryptocurrency is a digital currency where coding and encryption is used to create and use the “money”. In other words, bitcoin is literally just code on a computer.

 

How does that work?

 

Each digital bitcoin is really just a bit of unique code. You might be thinking – copy and paste is a thing, right? So couldn’t someone just copy the code and paste the code numerous times, getting themselves loads of bitcoin and heaps of money? Nup, it doesn’t work like that.

 

 You, after realising you can't be a millionaire, after all

 

That’s because bitcoin isn’t bits of separate code just floating around. They’re all clumped together in something called the blockchain. The blockchain is a public, recorded collection of everything that’s ever happened with bitcoin – the creation of new coins, and the movement of them as people pay them to others (just like money). The blockchain also records who owns which bitcoin at every moment. For example, if Person A pays two bitcoins to Person B, this latest transaction is added to the end of the blockchain, and checked by computers. These computers record that the owner of the bitcoin has changed (from Person A to Person B), ensuring that no one can copy and paste and use the code again as if it were a new bitcoin. (Note: pay attention to this sentence. It’ll be important later).

 

The unique thing about bitcoin, and cryptocurrency more broadly, is that it doesn’t need a bank or central government to watch over it. Everything is independent – you don’t need to store bitcoin in a bank, and the government doesn’t control how much bitcoin there is at a single time. It operates on what’s called a “decentralized peer-to-peer network”, basically meaning that Person A can do business with Person B using bitcoin, without a bank or government in between.

 

 

Where does bitcoin come from?

 

First, bitcoin can be bought, with normal currency – i.e. Australian dollars. People do this through online exchanges. So, if I wanted to buy one bitcoin, currently I’d need around $9000, which I’d swap for a unique bit of code – my new bitcoin.

 

Second, people can make completely new bitcoin, by “mining” them.

 

 Not that kind of mining, sis

 

Stay with us here, because the process of “mining” new bitcoin is a little complicated – and a little weird.

 

Okay, cast your mind back to the blockchain, and how each new transaction is recorded. The blockchain records when Person A sends Person B a certain amount of bitcoin. However, someone needs to work out whether or not that transaction is legit – maybe Person B faked it, or maybe Person A never owned that bitcoin in the first place. It’s like when a bank lends money to someone – before they do, they check that person’s details (name, address, income, credit history etc.) But we said that bitcoin works without banks or governments. So who does the checking?

 

Computers. (Or, “nodes”: the name for computers that are connected to the blockchain network because they have the bitcoin software installed. Any computer with enough energy and storage capacity can be a node).

 

Obviously, we’re not saying that computers act like human beings, checking into people’s lives to see if bitcoin transactions are legit. Instead, what they do is solve some very complex mathematical equations that will do a similar thing. The answer to these mathematical questions is a number, and in order to solve it, nodes basically spit out a bunch of random numbers and try to fit it into the complicated equation. And the first node to get the answer receives a reward – new bitcoin.

 

Every time there’s a new bitcoin transaction (aka some bitcoins move from one person to another) – all the nodes connected to the blockchain start trying to find the answer to the equation (like a bunch of competitors at an academic decathlon). The first computer to find the magic number gets the prize (brand new bitcoin). And the owner of that particular node has just “mined” new bitcoin.

 

 

Although it’s really the nodes doing all the work, mining bitcoins isn’t super easy. The mathematical equations get harder and harder, and the rewards get smaller and smaller, depending on how many nodes (and people) are trying to find the magic number at one time. So, when bitcoin itself was a relatively new and obscure cryptocurrency, it was way easier to mine new bitcoin. Now, there’s loads more competition. And because of this, it comes down to how powerful your computer is – mining bitcoin takes a whole lot of electricity and powerful hardware. The faster your computer (and the more electricity it eats up), the more chance it has of finding the magic number first.

 

Also, you might be thinking: if new bitcoin can be mined like this, then is there an unlimited supply? Can someone theoretically mine new money whenever they need it? Not quite. The person who originally created bitcoin (who’s anonymous and mysterious, btw) put it into the bitcoin program code that only 21 million bitcoins can ever exist. So, once we hit that 21 million maximum, there won’t be any more mining.

 

So how is bitcoin used?

 

Like any other currency. People who own bitcoin have an encrypted (meaning the data is hidden through code) digital wallet on their computer. They have a “key” (more code) to their wallet, that is essentially their password to unlocking it to spend bitcoin. Keys are generated through websites online. With the key, you can essentially use bitcoin like normal money. Gift cards, hotel rooms, apps – they can all be bought using bitcoin.

 

And that was our  Economics Explainer! Although certainly unusual and complicated to understand, bitcoin is certainly an interesting aspect of our economy, with a hotly-debated future usefulness. 

 

 

Sources

https://www.abc.net.au/news/2013-12-02/bitcoins-the-digital-currency-explained/5119034

https://www.coindesk.com/information/how-bitcoin-mining-works

https://www.abc.net.au/news/2018-11-27/bitcoin-is-having-a-terrible-year-its-value-just-plunged-again/10557842

https://www.coindesk.com/information/what-can-you-buy-with-bitcoins

https://www.economist.com/the-economist-explains/2015/01/20/how-bitcoin-mining-works

 

 

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